Set out what drives the yield gap between conventional bonds and inflation-linked bonds
The idea
The yield on a conventional government bond minus the real yield on an inflation-indexed bond of the same maturity is the break-even inflation rate. It is not a pure forecast: it equals expected inflation plus an inflation risk premium that holders of conventional bonds demand for bearing uncertainty about future inflation. Liquidity also matters, because index-linked markets are usually smaller and thinner; a liquidity premium in index-linked yields narrows the measured break-even without any change in expectations. Break-evens tend to widen when expected inflation or inflation uncertainty rises, often in strong expansions, and to narrow in downturns. The trap is treating the break-even as expected inflation without removing the risk premium, which overstates expected inflation when that premium is positive.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Economics and Investment Markets
- Explain why an economic factor can move market values only by acting on at least one of three channels: default-free rates at each maturity, how large and how soon expected cash flows are, and risk premiums
- Explain how expectations, and revisions to them, drive the prices markets set on assets
- Set out how an economy's long-run growth rate and the volatility of that growth relate to the typical level of real short-term rates
- Explain how each stage of the business cycle shapes policy and short-term rates, the steepness of the yield curve, and how bonds of shorter and longer maturity perform against each other
- Explain how credit spreads, and returns on credit-sensitive fixed-income securities, shift as the business cycle moves through its stages
- Explain how the nature of the markets a company sells into bears on its creditworthiness
- Explain how the equity risk premium is linked to how well equities hedge consumption
- Explain how the stage of the business cycle shapes expectations for earnings growth over both short and long horizons
- Set out how valuation multiples change over the business cycle
- Set out the economic drivers of investment in commercial property